June 2001

FSA’s Head of Life Insurance tells Chief Counsel A that he would like to discuss the issues raised in her note of 31/05/2001 [19:20] about the terms of reference for the Independent Actuary for the compromise scheme. The Head of Life Insurance says that he wondered: ‘whether we are putting more weight on the [Independent Actuary’s] report than it can reasonably bear. I think this report is not actually required under [section 425 of the Companies Act 1985] as distinct from a schedule 2c [of ICA 1982]? And we have agreed that the [terms of reference] should not be subject to our approval, so any suggestions we have need to be put forward in that light’.

[12:18] Line Manager E prepares a letter to be sent to Equitable. The Line Manager explains to the Head of Actuarial Support that he did not intend to raise his outstanding points at that time, but intended to do so when the next draft documentation was received.

[12:27] The Head of Actuarial Support explains that his ‘main worry about not including my list of questions at this stage is that there is not enough time to cover these properly at a later stage’.

Equitable send FSA information on the calls to Equitable’s helpline and on the value of transfers, surrenders and switches. Equitable note that they were ‘blithely sending these to you on a weekly basis’ and ask if FSA still required this information.

Line Manager E asks an official to telephone them to confirm whether FSA needed to continue to receive this type of information.

FSA write to Equitable about the terms of reference of the Independent Actuary for the  compromise scheme. FSA say they were likely to place considerable reliance on the views of the Independent Actuary, when deciding whether or not to exercise their intervention powers in relation to the compromise scheme. FSA set out four areas of work that were not expressly referred to in the terms of reference, but which they believed should be specifically considered and reported on, those being:

a)the present value of GAR rights, with any appropriate breakdown by types of policy;

b)the basis of which any uplift would be calculated for the purposes of the compromise;

c)the basis on which policies will be valued for voting purposes; and

d)whether it will be sufficiently clear within the documentation to be put to the Court, what the impact of the scheme would be on various relevant categories of policyholder within each class.

FSA’s Insolvency Practitioner attends a meeting of Equitable’s Compromise Scheme Steering Group. According to the Insolvency Practitioner’s report of the meeting, the items discussed include: the plans for the process of completing the scheme; progress to date on various issues, including that Equitable’s actuarial report was not yet finished; and remaining legal issues. It is noted that written instruction had not yet been sent to Counsel but that he had been briefed orally on ‘phase II’ of his opinion.

[16:15] The Head of Life Insurance says that he hoped FSA would receive the actuarial report within the next day or two and asks whether, in light of the slippage in the timetable, FSA’s deadline for comments would be extended.

[16:26] FSA’s Insolvency Practitioner says that: ‘[Equitable’s Chief Executive] acknowledges that our comments will be made on an ongoing, iterative, basis. Indeed, there are at least 4 documents to comment on: the actuarial report, the “launch” document, the full explanatory statement, and the legal contract. The last three will not be available until after 26 June. They hope to catch up the week lost in the two week’s delay before the road-shows when [the Chairman] is away. [The Chief Executive] did not explicitly mention the 26 June as a deadline but I got no sense that we were being boxed in’.

PIA send FSA a revised version of their draft ‘Stage 2’ report into Equitable’s disclosure to potential with-profits investors after the Court of Appeal decision. The executive summary and findings of the report are as follows:

2.1) This report concludes that Equitable’s disclosure met regulatory requirements in that, given the nature of the risks it faced, it was not required by the Rules to disclose these risks to potential new investors.

2.2) Equitable rightly regarded the [House of Lords’] ruling beyond the [Court of Appeal] decision as highly unlikely.

2.3) The [House of Lords’] ruling, which created a population of GAR policyholders who, by investing further into their existing policies, might receive significantly more than asset share in return for their extra investment to the detriment of non-GAR with profits investors was again rightly regarded as highly unlikely.

2.3.1) The impact of reserving for this liability was borne by those existing investors who had entered the with profits fund whilst the prospect of the eventual [House of Lords’] ruling was rightly regarded as remote.

2.3.2) The impact of reserving for the increased GAR liability was not borne by new investors after the [House of Lords’] ruling.

2.4) The possibility that a purchaser might not be found on the terms Equitable sought and that, without a purchaser, it might need to close to new business was rightly regarded as highly unlikely. It is not clear that the closure to new business will have a negative impact on future investment performance.

2.5) The above are regarded as operational risks experienced by Equitable. PIA has no clearly established rules requiring the disclosure of operational risks to potential investors. Moreover, it is clear that PIA has not acted previously to discipline a firm for non-disclosure of such risks or that it has ever acted to force a firm to disclose such risks.

2.6) This report recommends no further action to consider Equitable’s disclosure to potential investors before or after the [Court of Appeal] decision.

FSA’s Legal Adviser D provides the Director of GCD with a note (dated 5 June 2001), in response to his query of 30/05/2001 [16:55] about what constitutes a liability under a section 425 scheme. The Legal Adviser says that she had not intended to mislead by using the word ‘liability’, but was ‘anxious to demonstrate how flexible a section 425 compromise can be’. Legal Adviser D explains:

The word “liability” is not used in s.425 but I consider it right to stress the use of the word “compromise” throughout this section. I also consider it important to note the definition section in s.425(6) which provides:

(a) “company” means any company liable to be wound up under this Act, and

(b) “arrangement” includes a reorganisation of the company’s share capital by the consolidation of shares of different classes or by the division of shares in to shares of different classes, or by both of these methods.

To my mind this definition section highlights that a s.425 compromise is a very different animal from a scheme of arrangement and can be a mechanism for achieving considerably more than just a compromise with creditors.

Legal Adviser D provides some extracts from section 425 cases, in order to emphasise the flexibility of such schemes. The Legal Adviser concludes:

I realise I have not answered your question but I believe it to be inherent in the words “compromise” and “arrangement” that what can be compromised are not just contractual claims or guaranteed liabilities in the sense of the guaranteed annuity rates confirmed by the House of Lords in the [Hyman] case but could include rights to a terminal bonus both of a particular amount or calculated on a particular basis. Any compromise of these more ephemeral (as opposed to strictly contractual) rights would have to be one to which a reasonable policyholder would agree and thereafter be sanctioned by the court. This I believe to be the break on more fanciful claims or rights attempting to be compromised.

Legal Adviser D stresses that she had no experience of section 425 schemes or pensions law and says that her note had been prepared simply to save the Director research time. She recommends that he should consult with Counsel on the issue.

FSA meet the OFT to look through the complaints cases about Equitable’s application of the market value adjuster. FSA explain:

In nearly all these cases there is a question or questions relating to the mva and unfair contracts, and for each of these cases OFT will send the standard letter which [the OFT] showed us. [An OFT official] will sign these letters, which he hopes to send out tomorrow. A copy of this letter will be attached to each file.

Some of these cases also raised additional general questions about Equitable Life, for example, one asked about the rights of the GAR holders, another alleged mis-selling by Equitable Life. We will need to consider whether or how we will address these sorts of questions. From a practical point of view I did not feel we could ask OFT to add responses to these points to their standard responses, without considerably delaying the transfer.

The cases not raising questions about [unfair contract terms]/mva raised issues of a more general nature. In these cases, OFT has already sent a full/final response. These cases are now closed, and probably should not have been in the same pile. [An OFT official] has agreed to ensure he does not send the standard letter in these cases, as this would obviously commit FSA to further action. However, OFT will send the files to us for completeness, but separately identified.

OFT have already dealt with a number of more general enquiries/complaints about Equitable Life, as mentioned previously by [the OFT], and they have answered these in full. As [the OFT] mentioned, they will copy these to us silently. There is no action for FSA.

FSA take away with them the OFT’s main Equitable file, which included their correspondence with the company.

Further to the conference with Counsel that morning (for a record of which see Chief Counsel B’s note of 08/06/2001 [17:19]), Line Manager E lists some issues on which FSA needed to do some research, which were as follows:

1.[Counsel] asked about the operation of group and occupational schemes, and [were] interested in how they worked. For example, where there were trustees, who had the membership and voting rights and who was the policyholder[?] In what circumstances did the employees of companies have direct rights against Equitable. Unless anyone knows the full details of the schemes Equitable runs, I might ask for a note from them.

2.Did Equitable have any professional indemnity insurance for liabilities arising from mis-selling? (I am fairly sure they do not)

3.What assumptions are made for the purposes of the £1.5billion estimate of the GAR liability made post [House of Lords]? How sensitive is it to factors such as increased propensity to top up and changes to interest rates?

4.What kind of economic impacts can affect policyholders in different classes in different ways or by varying degrees Eg does a change in interest rate have the same impact on all policyholders? Are some advantaged/disadvantaged more than others? Does the benefit/detriment all go the same way?

5.What terms of with-profits policies can override other terms so that some policyholders have differential treatment to others? (The most obvious answer is that all contractual rights take precedence over discretionary benefits)

6.How ring fenced are subfunds? Do firms make a virtue of operating a number of subfunds, eg in their marketing? How do they treat subfunds for the purposes of the returns? How effectively are they ring-fenced for business and solvency purposes?

FSA’s Line Manager E seeks clarification from Scrutinising Actuary F on his understanding of the position of group schemes and occupational pension schemes.

[16:42] The Scrutinising Actuary explains that it was a complex question and FSA would need to ask Equitable who possessed the membership and voting rights in respect of various types of business, ‘but it will be important to ask the right questions to increase the likelihood of getting helpful answers!’. The Scrutinising Actuary gives an explanation of how group schemes would normally operate.

An HMT official informs HMT’s Director of Financial Regulation and Industry that the Economic Secretary to the Treasury was now content with the recommendation in his note of 24/05/2001 that she should note HMT’s intention to approve the section 68 Orders.

[11:39] The Director confirms that HMT could now give FSA their formal approval.

HMT grant Equitable the section 68 Order on the rates of interest used for fixed interest  stocks and the Order on the value ascribed to Permanent Insurance.

HMT send copies of the Orders to FSA.

FSA’s Chief Counsel B sends the Head of Life Insurance a copy of the note to PIA on the conference with Counsel the previous day, which concerns how PIA should take forward their work on their ‘Stage 2’ report. The note records the following:

Chief Counsel B explains the context for PIA’s report and notes that, alongside this, Counsel for Equitable had identified ‘broader and more extensive issues’. He notes that, in light of this, FSA and PIA had instructed Counsel to ‘track the [Counsel for Equitable] issues under consideration and, if need be, to identify any further issues which may be relevant to the claims of GAR and non-GAR policyholders. We do so in order that the FSA can have a well formed view as to whether the Equitable’s compromise proposals are appropriate and adequate. There is an expectation that [Counsel] will speak with [Counsel for Equitable] about how his views are developing’.

Chief Counsel B continues that: ‘Since there is obvious overlap between the issues under consideration by counsel (and by [Counsel for Equitable]) and the particular post-Court of Appeal misselling issues addressed in your draft report, we cannot move to finalise your report until the work with our external counsel is concluded’.

Chief Counsel B says that the rest of his report sets out the points from the conference with Counsel the previous day, but that: ‘Generally, counsel acknowledged that the supervisory judgments in the draft report had force. It would be reasonable for the regulator to take account of the extent to which Equitable had been at “fault” in deciding whether disciplinary action should be brought. It is however necessary to consider also whether Equitable has breached any non-fault-based obligations. In reaching a view on what Equitable considered were the risks at any time, the report relies on the firm’s explanation as given to us. We should, however, try to look at the original evidence to get verification’.

Chief Counsel B sets out Counsel’s preliminary observations:

The starting point is the profound implication of the House of Lords judgment which must be assumed to have been the correct statement of law throughout. From the moment that GAR and non-GAR policyholders co-existed in the same fund the non-GAR policyholders were exposed to the risk that they might inevitably be exposed to disadvantage if the value of the fund had to be used to support the costs of meeting the GAR contracts. This can be expressed as a risk that the non-GAR policyholders would not get their “asset share” in circumstances where the GAR option became valuable. Counsel agreed that the concept of “asset share” is not necessarily something which can be translated into a contractual entitlement. It was also acknowledged that there are, for example, analogous risks, that a life office’s mortality experience might be such as to impact upon the value of other classes of policy not affected by such experience, that a life office’s exposure to common law misselling claims is an expense which may be wholly or substantially attributed to the fund. Distinctions may, however, be drawn between those risks about which a policyholder might reasonably be taken to be aware and others which should or need to be drawn to his attention.

Chief Counsel B goes on to set out Counsel’s preliminary views on the mis-selling issues identified by Counsel for Equitable, under the headings of ‘Implied term’, ‘Contractual warranty’, ‘Good faith duty in insurance contracts’, ‘Other common law actions’ and ‘Breach of statutory duty – regulatory misconduct’. Under the first heading, Chief Counsel B reports that Counsel is:

… deeply sceptical as to whether it is feasible, in the light of the House of Lords judgment, to mount a case that the non-GAR policies should be construed on the basis that they contained an implied term that the asset shares for such policies would not be prejudiced by virtue of the Society’s exposure to GARs. This is because Lord Steyn held that the Articles of the Society should be read as subject to an implied term that the directors would not exercise the discretion to reduce bonuses for GAR policyholders opting for the guaranteed annuity. Once that is accepted it seems inconceivable that a Court would be persuaded to imply a further term into the Articles or policies which would not be reconcilable with the House of Lords ruling.

Under ‘Contractual warranty’, Chief Counsel B reports Counsel’s view to be that:

It is possible that the Equitable, through the sales process, made promises to non-GAR policyholders which should be given contractual effect – a collateral promise or collateral warranty to the effect that non-GAR policyholders would not subsidise the costs of meeting the GAR policyholders. This would depend, however, upon the facts of each case. The preliminary reading of the sales literature supplied to counsel suggests that such warranties were not given but this needs to be further investigated particularly by reference to the briefing material given to Equitable salesmen. We should ask to see, if they are available, the records of training and sales briefing given to Equitable salesmen.

Under ‘Good faith duty in insurance contracts’, Chief Counsel B reports:

The insurance contracts sold by the Equitable attract the good faith duty of disclosure. This is a duty to disclose all such facts as would be relevant to a policyholder’s decision to take out a policy and would include such facts as would have been known to the Equitable on reasonable enquiry. Clearly the Equitable could not have known, at least from 1988 until some stage in the litigation, that the Court would prohibit the exercise of discretion to reduce terminal bonuses for GAR policyholders. There will however be a subsidiary issue here, namely, whether the good faith duty of disclosure required the Equitable to disclose the risks presented by the litigation which the Society faced from 1998 onwards. A breach of the good faith duty of disclosure does not give rise to a claim for damages but merely for rescission of the contract. However, rescission of the contract, return of premiums plus interest, may be a valuable remedy for persons who bought Equitable policies at a late stage, particularly during the course of the litigation. The good faith duty, however, is one which is conditioned by fault i.e. it would be necessary to show that the Equitable knew of a particular risk, or ought reasonably to have known of such a risk, in order to succeed with the claim. On the fact of it, this may confine the issue to such time as the Equitable knew there was a material risk that the Court would condemn its practice of awarding a reduced GAO, or, alternatively, that it could not award a lower bonus to GAOs as a class.

Under ‘Other common law actions’, Chief Counsel B notes that Counsel said: ‘It is conceivable that policyholders could seek to frame their claims in negligence or misrepresentation, again both fault based actions’.

Under ‘Breach of statutory duty – regulatory misconduct’, Chief Counsel B records:

This is relevant to the period from 1988 when the Lautro disclosure rules came into force (July 1988) and obviously requires an analysis to be undertaken as to what the rules at any time required. The central issue is whether the rules are to be construed as being fault based or whether they can be construed as giving rise to liability without proof of fault or negligence. Putting the question simply, was the Equitable under a regulatory obligation to provide information (as to the matters which might affect the ultimate value of a policy) which must be construed as including the disclosure of facts as subsequently substantiated by the House of Lords, or, only those matters which it would have been reasonable for the Equitable to have disclosed at the time.

The language of the Lautro rules does, superficially, appear capable of creating strict obligations. Counsel acknowledge however that a Court might be slow to reach such a conclusion if this were to produce extreme or absurd results. A Court might well be persuaded to read the rules subject to the necessary implication that any disclosures which they required were disclosures of matters which were known to the Lautro member or which, with reasonable diligence, could have been discovered by the firm. Persuading a Court that this is the right approach might require the regulators (and/or the Equitable) to show what consequences would follow if strict liability were to be applied. It would be helpful in this context if counsel could be provided with some analogies. At the conference we discussed, for example, the position of a life office which had written a book of policies which, unknown to it at the time, would be likely to expose it (and consequently other policyholders) to severe claims arising as a result of AIDS. Counsel is not suggesting that these questions need to be tested in Court – they are matters they will take into account in reaching a view.

If the regulatory rules (throughout the period) either expressly or, as a matter of construction, are not fault based then the Equitable’s potential liability will turn upon whether it failed to disclose matters of which it had knowledge, or, which with reasonable diligence, it could have ascertained. This leads on to particular consideration as to whether the Equitable should have disclosed the risks presented by the litigation. This can be broken down into questions as to whether the Equitable should have disclosed to potential policyholders the fact that it was in litigation as to the treatment of GAR policyholders or more particularly whether there was a risk that it would be unable to meet its liabilities to GAR policyholders without drawing on the value of the fund supporting the entire population of policyholders. At this point it will be necessary for counsel to advise on the extent to which it was reasonable for the Equitable to rely upon their legal advice as to the nature and severity of the risks which were being faced. There is a particular point here in relation to the “ring-fencing” issue. [This] arises from the Equitable’s apparent position, post-Court of Appeal, that the option of treating GAR policyholders as a class and thus ring-fencing the costs of the GARs to that class nevertheless remained open to them.

It is not clear from the Court of Appeal judgment whether there was argument on this particular point. At what point did the Equitable receive advice that this form of ring-fencing might be challenged and, as it was, struck down in the litigation? Counsel want to see the skeleton arguments presented to the Court of Appeal and the lower Court and, if possible, transcripts of both of those proceedings.

There is a more general point relating to the Equitable’s assessment of the risks which it was facing. The [PIA] report is based upon the Equitable’s account of the legal advice which it received and the decisions which it subsequently took. However, in answering questions about the Equitable’s state of knowledge and what it would have been reasonable for it to disclose it will be necessary to look further and in particular at the legal advice which it received and the decisions which its board took over the period in question. We cannot simply rely upon what the Equitable has told us about this. Accordingly, counsel would like the FSA to examine the Equitable’s legal advice in its entirety starting from the point in 1998 when the complaints from GAR policyholders began to emerge and including the advice which it received during the course of the litigation.

Next steps

Chief Counsel B lists the further material that needed to be sent to Counsel, along with a list of the officials responsible for collation of it. Chief Counsel B also states that Counsel had made it clear that he would not wish to complete his opinion until he had seen at least a draft of Counsel for Equitable’s opinion.

[17:19] Chief Counsel B also sends a copy of the note to FSA’s Chairman, as he understood that he was going to read PIA’s report over the coming weekend.

[17:54] An official from the Chairman’s office notes that, at a meeting with the Chairman earlier that day, it had been agreed that an FSA director would take forward this work. That director had in turn said that he would hold a meeting on it early the following week, to which he would invite Managing Director A and the FSA’s Managing Director and Head of Consumer, Investment and Insurance Directorate (Managing Director B).

FSA’s Equitable supervision file includes an article from a newspaper in which FSA’s Chairman is quoted as saying, in relation to the compromise scheme, that: ‘We certainly think this is the best hope for policyholders. This is not a zero-sum game’; and ‘Halifax will put in additional funds and, if members cap the liabilities through the compromise, there is no reason to think that, going forward, investors in the Equitable Life will do any worse than any others’.

The Chairman explains that the Tripartite Standing Committee had considered whether there was a case for the government to ‘step in and prop up the company’. FSA’s Chairman says: ‘We didn’t think the case was made for a government bail-out. There are plenty of investors whose investments do not return what they had hoped. Despite everything, Equitable Life has been quite a good performer. There will be other companies where investors have had lower returns’.

FSA’s Legal Adviser D replies to the Chairman’s questions of 01/06/2001. She says that FSA would see the Independent Actuary’s report for the compromise scheme. On the second question about whether FSA would send something to policyholders, the Legal Adviser answers that: ‘it depends on whether the FSA broadly approves/agrees with the proposed compromise and how clearly it is explained. The FSA can send out its own missive to policyholders if it was not happy with the substance of the scheme and/or considered that it was not explained sufficiently clearly … At the moment it is impossible to say whether the FSA will do so or not’.

The Director of GCD later (on 15 June 2001) advises Legal Adviser D that she should work on the basis that FSA would want to write to policy holders.

Having seen a copy of Chief Counsel B’s note of 08/06/2001 [17:19], the Head of Actuarial Support provides an outline of some other types of risk that could be disclosed to potential policyholders. Those being investment risk, mortality risk, expense risk, taxation risk and operational risk.

[11:38] Line Manager E forwards the note to PIA.

FSA’s Director of GCD is sent a copy of FSA’s note of the meeting with Equitable’s Chairman of 01/06/2001, as requested. [15:37] Having seen the note, the Director of GCD expresses his concern to the Director of Insurance that, as FSA had not yet received the legal documentation for the compromise scheme which had been promised by 5 June 2001, Equitable’s Chairman might mistakenly believe that everything was running to time and that FSA would have reviewed the draft documents in time for Equitable’s Board meeting on 25 July 2001. The Director of GCD asks the Director of Insurance if he could find out what was going on.

[16:17] The Head of Life Insurance says that FSA had received Equitable’s actuarial paper and suggests that this might have been what their Chairman was referring to. The Head of Life Insurance also informs the Director of GCD that he had spoken to Equitable’s Chief Executive, who had admitted that the timetable had slipped but had said that he believed that Equitable had met their target by sending the actuarial paper. The Head of Life Insurance also reports that the Chief Executive had said that the Society’s solicitors were concerned that changes to the actuarial paper would have dramatic effects on the legal paper. The Head of Life Insurance tells the Director of GCD, however, that ‘our separate requests to see legal advice in relation to potential misselling has made [Equitable’s Chief Executive’s] task more difficult, because their lawyers are now even more nervous about what they show us on the compromise’.

[17:06] The Director of Insurance informs the Director of GCD that he too had spoken to Equitable’s Chief Executive that day, on other business (see 13/06/2001 [17:17]), and had been told that he was not yet satisfied that the actuarial paper was adequate. The Chief Executive had said that Equitable’s Chairman was under no illusion on the extent of progress.

FSA’s Director of GCD comments on Chief Counsel B’s note of 12/06/2001 [12:41] that there appeared to him to be a distinction to be made between two issues:

The first is about the standard of conduct which a rule requires. Does it require an absolute standard, or only that reasonable steps should be taken …

The second is about how a particular rule should be construed. I believe that it is a principle of interpretation that a rule should be construed in such a way that it is possible to comply with it. The Lautro disclosure rules can be complied with if they are construed to require disclosure of information [which] the firm knew or could with diligence have known. They cannot be complied with if they are construed to require disclosure of information where this is not the case. Therefore that cannot be the proper construction.

FSA’s Director of Insurance informs Line Manager E that he had telephoned Equitable’s Chief Executive earlier that day to find out what he wanted to discuss at a meeting that had been arranged for 19 June 2001. The Director says that the Chief Executive wanted to discuss the extent to which Equitable would need to submit ‘non-standard’ returns. The Society’s Chief Executive had explained that he thought that there would be a need to refer to ‘fundamental uncertainty’ and he would like to follow the formula used in the Companies Act reports and accounts. The Chief Executive had also expressed concern that the new directors ‘will need to indicate that the matters which they certify are certified “to the best of their knowledge and belief”’. The Director of Insurance says that he knew the Chief Executive had raised this issue previously with the Head of Life Insurance and he asks Line Manager E to find out if FSA had reached a view on it or had found any precedents.

[17:30] Line Manager E says that FSA were not clear what changes Equitable had in mind but ‘as a matter of policy we are inclined to think that honesty is the best policy’.

[19:15] The Head of Life Insurance says that he would let Line Manager E have the responses to his trawl of supervisors for qualifications that had been made to certificates.

FSA and their legal advisers hold a conference with Counsel to discuss various issues about the compromise scheme. According to a draft FSA note of the meeting, Counsel advised on the following issues:

Actuarial report

Counsel states: ‘that the reasons for the Actuary making a distinction between premium-paying and non-premium paying policyholders and a further distinction between those who paid premium in 2000 were not stated/unclear’.

It is agreed that the alternatives to a compromise scheme should be spelt out and it is noted that: ‘Such explanation might elucidate whether the compromise proposed was fair or not’. It is recorded that the actuarial report, as drafted, did not do this, nor had it been intended to do so.

It is agreed that the 60% take-up rate for individual and group scheme policyholders required justification and it is queried why the proposed uplifts differed for the two types of policyholder (the uplifts being 23% and 20%, respectively).

FSA note that there was ‘general concern because the actuary had first worked out the total cost of paying all GAR policy holders in full, then looked at sharing out the available pot according to the GAR rights, rather than taking as the starting point the value of the GAR rights. [Chief Counsel A] noted that Equitable might have no alternative to this approach and if so, the FSA would need to ensure that policyholders were given a very clear explanation of it’.

Counsel queries whether Equitable’s £1.5bn GAR provision had already been discounted by 60% (reflecting the Actuary’s take-up rate assumption). Counsel says that, if this was the case, then GAR policyholders were getting less than the full value of their rights. Counsel asks whether this could be justified as being fair. Chief Counsel A notes that there could be a misunderstanding on this point, due to the differences between reserving requirements for the ICA 1982 returns and the Companies Act reports and accounts.

Counsel says that it seems ‘non-GARs money was being used to “buy-off” the 700 pre-1975 GAR policyholders’.

It is agreed that fuller information was needed about group schemes and the role of the actuary in appearing to determine the policyholder voting classes is queried.

Role of FSA

The note records:

[Counsel] suggested the FSA’s role in a s.425 compromise was to ensure that it was fair to policy holders, to ensure that the voting was fair and that the explanatory statement was clearly written. [Counsel] explained that the Court will look to both the independent actuary and the FSA for help. [Chief Counsel A] responded that the FSA is also guardian of policyholders’ interests and would intervene to protect them. [Counsel] stated that maybe Equitable policyholders’ reasonable expectations were for full GAR rights.

Solvent entity

Counsel states that ‘the oddity of this proposed compromise was that an apparently solvent insurer was requiring policyholders to give up 40% [of] the value of their rights’. The discussion continues:

It was noted that [the report] appeared to suggest that those who retired now could do so taking full GAR benefits and thus get £1 in the £1 at the expense of those who had to wait for the compromise who would not get more [than] 60p in the £1. When was the clock going to stop – a cut-off date be established. [Chief Counsel A] replied that there was always an inherent unfairness in such compromises and there had been a similar difficulty in the … scheme [of a named company]. Many policyholders would prefer to get 60% (eg, those who preferred the cash option, those who risked losing all GAR value if the market improved and so on).

[Counsel] suggested that if the Equitable was solvent why is the Equitable not treating the with-profits fund as a closed fund and simply waiting to see if all policyholders take up their GAR rights. It was explained that this left open the possibility of top-ups and a deterioration in the market. In addition, investment freedom would continue to be restricted. If this paragraph suggested it was beneficial for some policyholders to retire now on full GAR benefits ahead of the scheme, [Counsel] queried whether the FSA should take steps now to ensure policyholders were informed. [Chief Counsel A] agreed it would be important to ensure that policyholders were made aware of the options available to them.

[Counsel] also queried whether GAR policyholders should simply be required to stop paying further premiums. Surely one solution was to persuade GAR policyholders to give-up their “right” to pay further premiums now. [Chief Counsel A] noted that this would still leave Equitable’s investment freedom constrained.

Involvement of the Policyholders Protection Board

FSA’s legal advisers query whether the Policyholders Protection Board ‘should be invited to pay-in money to Equitable now as they had done in [a previous] case. Those present stated that this option was very unlikely to be favoured by the [Policyholders Protection Board] in the case of a solvent company’. Chief Counsel A agrees to inform the Policyholders Protection Board so that they could take their own view.

Under ‘Next Steps’, Chief Counsel A states ‘on several occasions during the meeting that the FSA had regularly asked for a draft scheme from [Equitable’s solicitors] and draft explanatory statement without success’. Counsel note that ‘the threat of the FSA being unable to approve the proposed scheme was now real given the short timetable and should be made clear to both Equitable and [their solicitors]’. Chief Counsel A says that this had been done and would continue to be done.

FSA write to Equitable ahead of the meeting the following day. FSA set out the queries they had identified with the actuarial paper (see 11/06/2001 [15:42] and 12/06/2001 [18:26]), those being:

1. … does the increase of £1.3 billion in the Society’s free assets, if a scheme is adopted, arise from the combined effect of releasing the prudential margins in the GAO reserve (compared with the “best estimate”) and also a lower resilience reserve?
2. … one of the assumptions is a smoothing adjustment of 0.55% p.a., compared with 0.3% p.a. previously. Why has this value been increased when the philosophy has not changed? That paragraph also refers to policy values being significantly “less” than asset values but should it not say “more”?
3. … we note that you say that age is not a material factor in the cost and yet this appears to be inconsistent with the figures shown in the table in section 4.4. Are you able to explain the comment?
4. There is a reference … to the Board considering several alternative schemes. This sits rather uneasily with the concept that the present draft represents a fair best estimate of the value of the GAR benefits, that are then apportioned fairly by the scheme as an uplift of benefits across all the relevant policyholders. Can you clarify what elements may be subject to review?
5. … you mention that the benefits under pre 1975 policies are less valuable than those under post 1975 policies. However, is it not also the case that in recent times there will have been a more significant number of people taking retirement benefits from pre 1975 policies than post 1975 policies and that the balance will shift as the older people retire? How have you allowed for this in calculating the GAR value for post 1975 policyholders?
6. The report indicates that it is now intended that the scheme should differentiate between premium and non-premium paying policyholders. How will you operate this distinction when in practice all policyholders appear to retain the right to pay additional premiums at any time?
7. There is no differentiation made between males and females in the proposed uplift in benefits. From the figures … this appears plausible for most groups of policyholder, but for retirement annuitants, there might be a differential here of around 2 - 2.5% to consider. A similar (and possibly slightly higher) differential might also appear if we had regard to the present annuity rates available in the market for males and females …
8. The GAR/CAR ratios … have fallen compared with the figures in the 30 April draft. E.g. for post-1975 Retirement annuities, the ratio for a male retiring at 65 has fallen from 1.436 to 1.377, and for females at 65 from 1.417 to 1.352. Does this reflect an improvement in Equitable’s CAR’s in the meantime?
9. Can you clarify why those examples … for current annuity rates were selected? For example is there an objective reason why you quote figures for Sun Life annuities for males and Norwich Union annuities for females? Is it your expectation that once the uplift has happened, people taking retirement would or should take an annuity from another provider on the open market? Are you currently encouraging people to do  this anyway?
10. You now appear to be treating group policies in broadly the same way as individual policies. In particular you are now assuming a take-up rate of 60% for both and the proposed enhancement for group policies has increased to 20%. However the figures … show a lower actual take up rate for group business. This is clearly a difficult issue as your paper acknowledges. However, it seems to us that the group schemes may provide benefits that are more valuable than the GAR which means that the scheme members could benefit twice over – by an enhanced policy value from which they would take further enhanced benefits.
11. You are assuming a long-term interest rate of 5.5% for valuing annuity benefits. This is slightly higher than the current risk-free rate on gilts (on which market rates for this type of swap are likely to be based) but slightly lower than the rate of interest underlying the current annuity rates offered by other insurers as tabulated … Is your assumption intended to be an average of the implied rates of interest from these two sources? More generally, it would be helpful to have some further description of the sources of material available for the different approaches indicated … and an explanation of how these approaches have been reconciled.
12. How do you justify the assumed 60% take-up proportion in the calculation of a “fair” offer for a policyholder wishing to take all the annuity benefit in GAR form (and either maximum cash or no cash benefit)? Would this involve having regard at that stage to the difference between current annuity rates in the market, and annuity rates derived from the assumed 5.5% long-term rate of return?
13. Have you considered the application of financial option theory to the value of a GAR benefit that only becomes exercisable after a deferment period (generally equal to the number of years before the policyholder attains age 60)? This might well have an effect on the assessed value of GAR benefits by present age.
14. There is little variation in the value of GAR benefits by age for individual policies … However, there is considerable variation for group policies. Can you provide further explanation.
15. We shall need to see separate tables for paid-up and premium paying policies, especially if you intend to distinguish the uplifts between these. In particular we would want to see adequate justification for the uplifts of 20 and 24 per cent respectively for non paying and premium paying policyholders with Retirement Annuities.
16. We are having some difficulty in reconciling all these figures for the aggregate value of GAR benefits, and their potential sensitivity to changes in the assumptions with those shown in the annual returns.
17. Paragraph 9.1.3 in appendix E comments on communications with policyholders. It is unlikely that many will understand the benefits of a percentage uplift combined with enhanced investment freedom compared with retaining the GAR. It seems to us vital that some modelling is done to show what the effects are likely to be for real typical policyholders. In any event, we are likely to want to see some information of that kind before taking a final view on the scheme.
18. Some other miscellaneous points are as follows;
    1. As indicated at paragraph 12 above, have you considered applying financial option theory to value (1) the GAR option available at retirement and (2) the 3.5% guaranteed accumulation rate that policyholders are also being asked to renounce?
    2. Will the overall package be affected by movements in the value of equity (and other) investments covering the GAR liability?
    3. What is the reason for the strange pattern of figures (moving up and down) in the table in Section 4.4?
    4. Appendix C shows some policyholders aged 83 and 80 who have not yet taken benefits. Is this an error?
    5. On a point of detail, what is the origin of the factor of “ten” for valuing each with-profits annuity in Appendix D? And if that factor is used both to determine the value of the [with-profits] annuity and the number of votes for [with-profits] annuitants, does that not give a disproportionate share of the vote to [with-profits] annuitants.
    6. Similarly, why are you applying the “[Minimum Funding Requirement] liability” to derive the value of certain pension plans on pages 48, 49 and 53 of Appendix D?
    7. Appendix E uses uplift figures of 20 and 25 per cent which is inconsistent with the information on page 5.
    8. We could not understand the calculation, or the rationale for the calculation set out for “replacement benefits” in Appendix I. We were also unclear about the calculation of the replacement benefits (page 63), and the interaction between “x %” in those calculations and enhancements of 3, 20, 23 and 24 per cent. mentioned on page 5.
    9. We noted that there was a comment that for 20% of group schemes, data could not be split by age. This seems a significant proportion of missing data and we wondered if you would be looking to fill the gap.
    10. Section 3.3.10 says that the assumptions are that for individual pension benefits are taken at 60 or 65 and that for group schemes that you assume a pattern based around the normal retirement age. Can you explain and justify the differences (if any) in the assumptions?
    11. On page 32 there is a list of GAR policies that are not to be included in the scheme. That is clearly a matter for Equitable Life. However, we would be interested to know why you have proposed excluding those policies. It would also be useful to us to know what implications that has for future reserving since presumably not buying out those guarantees leaves a degree of uncertainty going forward.

FSA’s Managing Director A writes to the Director of Insurance about a letter to a Member of Parliament. The Member had written to FSA regarding correspondence that he had received from several of his constituents, who felt that they were not receiving the necessary information to make an informed decision about the proposed reorganisation of the Society. The Member had said that Equitable had not provided an illustration of the value of the GAR in respect of particular policies, but had instead enclosed a table so that clients could calculate this for themselves.

The Managing Director attaches a draft reply to the MP and invites comments. He writes further:

But he raises a perfectly fair question and I think we need to be on the front foot in responding. Personally (though I haven’t said this in the letter) I feel that what would be reasonable information to give a GAR holder before he/she votes on the compromise would be either a personalised quote or generic information that was accurate to within a small margin or – a poor third – a self-calculation aid to “do it yourself”. The trouble with this is that if it is simple enough for someone to do it themselves, why can’t the Society do it? If on the other hand it is too difficult for the Society to do itself how can it produce a comprehensive ready-reckoner?

FSA’s Legal Adviser D asks the Insolvency Practitioner for a copy of his paper on ‘counterfactuals/worst case scenario’ in the event that a compromise is not achieved.

[11:06] The Insolvency Practitioner sends her a copy of his paper of 19/03/2001 explaining that it sets out the consequences for Equitable of a liquidation, ‘although there are many alternative and better options to consider before liquidation is reached’.

[12:59] Line Manager E sets out the possibilities other than the compromise scheme open to Equitable as being:

1. they could go for a winding up, which for reasons established by the paper will have terrible consequences and we would expect to need to intervene to stop it happening; or
2. they would have to soldier on and look at a much more cautious investment strategy as time goes on with bonus levels getting less and less generous, or even reduced to nil.

The Line Manager does, however, note that there were some other potential ‘ways forward’, including that it ‘might be possible to do some restricted insurance business transfers to other life offices (assuming there were any prepared to take it on), but (i) that could cause problems about frustrating the GARs and (ii) may not be possible because of the terms of the Halifax deal … But those are too remote and hypothetical for us to assess at this stage’.

[13:19] Chief Counsel A suggests that FSA should hold a short meeting to discuss counterfactuals, as she thought that FSA ‘may wish to do a bit more eg on how we might react should the solvency margin be breached’.

FSA’s Director of GCD writes to Chief Counsel A (copied to other officials), ahead of the meeting with Equitable that afternoon which she was attending, saying that he was rather worried about the current state of play on the compromise scheme. The Director of GCD says that Equitable’s draft actuarial report on the scheme did not make a convincing case for people to give up their GAR rights. The Director says that he believed that a case could be made for this, but it would need to explain that the alternative would be far worse. He says that the report apparently proceeds on the basis that there had been an actuarial valuation of the rights of the GAR holders, and that they were being offered the value of those rights. The Director of GCD says that this might not be a convincing argument. He notes that the amount available to uplift policy values was the required reserve for the guarantees, which was the £1.5bn that Equitable had based on a likely take-up rate in GAR rights of 60%. The Director of GCD says:

The difficulty is that the actual value of the rights to each policyholder is not the same as his proportionate share of the expected aggregate take-up. For those policyholders who would have exercised the right, their uplift is worth only 60% of the value of those rights.

As far as I can see, there is no way of avoiding this, because the company has no other resources to provide for the uplift. But it is highly relevant to the basis on which the scheme is justified.

(Note: the Director of GCD had prepared a draft that was to be sent to Managing Director B but the recipient appears to have been changed after comments on it from Chief Counsel B.)

FSA meet Equitable and their solicitors to get an update on the compromise scheme.

Timetable for the compromise scheme

Equitable set out the timetable and having done so: ‘it was impressed upon the visitors that this meant that the FSA had to be effectively satisfied that it had no fundamental objections to the 425 scheme by 25th July. There would be little point in the Board sanctioning an approach and consulting members more widely if we were minded to object. [FSA’s Head of Life Insurance] stressed that the 25 July date was very close and expressed concern that we did not have enough material at this stage to come to a view. Furthermore if more material is forthcoming we needed sufficient time to consider this’.

In order to be able to give their ‘blessing’ for the scheme, FSA explain that they would ‘wish to be content that the process was thoroughly prepared and appeared adequate and transparent and that we had no reason to object to it in substance’. Equitable say they are confident that they will be able to give FSA the reassurance required.

FSA note that ‘When pressed as to what “the test” should be on … deciding whether this scheme was better than other options [Equitable’s Appointed Actuary] confirmed that ELAS were still grappling with this’.

FSA highlight that they ‘may face difficulties with the scheme if certain groups or even individuals are significantly adversely effected. [Equitable’s Appointed Actuary] argued that the most extreme group effected would be GAR policyholders past retirement age, however, these policyholders would still have the right to take … up their full GAR pension provided they did this before the effective date of the compromise. Otherwise [Equitable’s Appointed Actuary] thought that appropriate differentiation of value issues had been considered and were broadly fair. They did, however, agree to do more analysis on pre 1975 policies’.

Discussion of FSA’s letter dated 14 June 2001

The discussion includes answers to the following questions (following the numbering in FSA’s letter):

1)Equitable confirm that the ‘bulk’ of the £1.3bn increase in their free assets resulted from the release related to the resilience reserve, but also ‘a slightly higher valuation rate of interest could be justified in view of the shorter duration of liabilities’.

2)On the changes to the ‘smoothing adjustment’, Equitable explain that the change ‘was deemed necessary because policy values and asset shares moved apart last year (because 2000 was a poor year for investment returns) and needed to be updated. The change will lead to a claw back on smoothing’.

4) FSA record:

It was confirmed that the ability for GAR policyholders to top up policies (at GAR rates) would be curtailed for those policyholders that had not previously topped up their policies in the last 12 months. This change of policy would be made at a Board meeting on 27 June and would be effective from 1 July. FSA thought that the Society had previously received legal advice that they were not able to halt top ups of this nature, since it had been thought that notice needed to be given before making such a change (and the very act of Notice may encourage policyholders unaware of their GAR benefit, to top up). However, ELAS now believed that they were able to do this and will make some kind of public statement relating to the change in policy. ELAS agreed to give us advance copy of any public statement made. It was also possible that a similar benefit available in Final Salary Schemes would also be cut off on this date. Subsequently, we have learned that they are intending to give notice to policyholders of this change, though they may not be aware that the “offer” in the compromise will depend on whether or not they are paying premiums. GCD have flagged this as a potential issue of concern that needs to be understood and addressed.

5)For the pre-1975 GAR policies, Equitable confirm that ‘benefits were much less generous than after this date but because the number of pre 1975 policyholders of this class were so few (about 700, less than 0.5% of GAR policyholders) there was less of a need to consider balancing considerations’. FSA tell Equitable that they were not yet persuaded that the 3% uplift for these policies was a fair offer.

10)Equitable state ‘the GAR option had now been given broadly the same value for groups as it had for individuals’. FSA say they had not received sufficient justification for the take-up rates used and go on to record:

It was still not currently known why Group schemes had a lower level of take up. Anecdotal evidence pointed to many of the policy values being small (and not worth the hassle of taking out the GAR). Furthermore other in house schemes have higher mortality and good investment performance which might make their schemes more attractive, and group policyholders seem more inclined to take cash.

The general principle of the scheme is to take into account the economic cost based on the current levels of take up and then divide this up between the GAR policyholders. [FSA’s Chief Counsel A] expressed some concern that the scheme was based on costs rather than focussing on the value of the individual rights. It was also possible that a Judge might want to focus on compensation for the value of the individual’s GAR rights. [Chief Counsel A] thought that it would be crucial to be very transparent about how this issue was being dealt with so that policyholders were aware of how much they were being asked to give up.

[Equitable’s Appointed Actuary] thought that these type of arguments went to the core of what the scheme was about and it was important to note that the scheme was a compromise. He added that currently there was no certain outcome for GAR policyholders. For example an important variant was interest rates. If they rose significantly the GAR policyholders could be seen to be getting something for nothing (as the GAOs lost value) to the detriment of the non GARs. [Chief Counsel A] noted that GAR policyholders who did not intend to take the GAR would also be better off.

Many of the other points are agreed or further information promised.

Under ‘Action Points’, Equitable agree to:

• formally respond to FSA’s letter of 14/06/2001;
• complete the actuarial part of the scheme and send it to FSA the following week;
• provide a roadmap or justification for the scheme;
• provide a statement on revoking the guaranteed annuity rates from applying on further premiums paid;
• provide details on the principles for uplift;
• clarify the materiality on pre-1975 policies;
• provide a definition of a group scheme;
• provide an explanation of how certain approaches in one part of the actuarial paper would be reconciled;
• expand a table within the scheme document;
• provide an update on their solicitors’ work on policy classes; and
• provide a reconciliation of the different GAR values given in various documents.

FSA agree to give Equitable an indication of what their ‘no objection’ or ‘fair and reasonable’ test would be.

On a version of the note of the meeting, FSA’s Chairman comments to the Director of GCD that: ‘Since they expect to go to court on 5/10, and there is a risk that our review may not be published before then, we need to consider just how material non-publication will be to those who face a choice’.

FSA’s Chief Counsel B seeks help from the Head of Actuarial Support in relation to his work on Counsel for Equitable’s opinion and PIA’s enquiry into mis-selling by Equitable. The Chief Counsel explains that Counsel had advised that ‘even if the Equitable has been guilty of a breach of duty of proper disclosure it would need to be established whether or not policyholders have suffered any financial loss as a result of that [non] disclosure. It is on that question that I would welcome some information which I can pass on to Counsel’.

[17:39] The Head of Actuarial Support advises Scrutinising Actuary F that they would need to think carefully about how FSA approach this, as FSA had information about conventional regular premium endowment policies but probably did not have readily available information on with-profits bonds or pensions policies.

The OFT send FSA a copy of a letter that they had sent that day to Equitable about the transfer of their enforcement action under the Unfair Terms in Consumer Contracts Regulations 1999 to FSA. The OFT’s letter says:

We have agreed that the FSA is best-placed to take effective industry-wide action in the interests of all investors. It gained powers to enforce the Regulations on 1 May and began the wide-ranging review of with-profits policies. The review includes scrutiny of the fairness of the terms and conditions which concerned us. Moreover, the FSA’s review covers the whole industry and not just Equitable Life. Today we transferred the numerous complaints we have received about Equitable Life including those relating to allegations of mis-selling and other matters.

FSA hold an Equitable Life Lawyers Group meeting. Chief Counsel B gives a summary of the discussion with Counsel for FSA about Counsel for Equitable’s Opinion on mis-selling of 7 June 2001. He reports that the advice of Counsel was that there needed to be significantly more work done before advice could be given.

Chief Counsel B reports that, at the meeting on 14/06/2001 [15:00], only Equitable’s draft actuarial report had been discussed, as there had been no update from Equitable’s solicitors on the proposals for the different policyholder classes. Chief Counsel B also informs the group of the discussions that had taken place with Equitable and their advisers on 15/06/2001 [15:00]. He notes it was clear that Equitable considered their current compromise proposals to be final. Chief Counsel B notes that the Director of GCD had expressed his concerns to the Director of Insurance and Managing Director A (see 15/06/2001 [13:09]) and had advised that the case for the compromise scheme had not been made.

FSA’s Head of Actuarial Support informs the Head of Life Insurance, Line Manager E and the Director of Insurance of an informal meeting that afternoon with the Independent Actuary for the compromise scheme. The Head of Actuarial Support reports that the Independent Actuary had expressed some concerns about the scheme and had indicated that he was far from being happy with it. In particular, he was not convinced that the deal was reasonable for non-GAR policyholders. The Independent Actuary had also mentioned that he had not seen FSA’s letter of 14/06/2001 or their comments on the actuarial paper. The Head of Actuarial Support suggests that there was a strong chance that the Independent Actuary would not give his approval to the scheme unless Equitable were able to provide a more substantive rationale for the details of it.

[18:21] Chief Counsel A suggests to the Director of Insurance that he should ask Equitable’s Chief Executive, when they met the following day, whether FSA’s letter of 04/06/2001 [12:41], (about defects in the Independent Actuary’s terms of reference), had been discussed with the Independent Actuary.

FSA’s Chief Counsel B provides advice to Line Manager E on the Rectification Scheme, in response to his note of 12/06/2001 [12:38]. The Chief Counsel explains that his earlier advice ‘suggested that it would be inappropriate to agree to an arrangement which effectively deprives the policyholder access to [the Personal Investment Authority Ombudsman], but as I see it this is precisely what the scheme will do’. The Chief Counsel advises that Equitable’s explanations ‘are very unclear about how they will inform policyholders about the availability of the Ombudsman – I think they should be pressed to make the position clear, and for our part we should make clear the limits we think should be observed in terms of the Equitable’s ability to exclude jurisdiction’. Chief Counsel B also provides some advice in relation to the LAUTRO/PIA Rules on advertising and on ‘Product Particulars’ and ‘Key Features’ documents.

[18:16] Line Manager E says that he shares Chief Counsel B’s ‘unease over [Equitable’s] interpretation of what had been said previously. Intuitively it seemed odd to say “If you disagree with our view you may have it reviewed by one third party. You may choose whether to opt for a third party under our direct control or one who is independent”.’

[21:32] PIA inform FSA that Equitable had told them that, due to the concerns expressed by PIA and the Personal Investment Authority Ombudsman, the Society now proposed that the arbitrator should act as an adviser and mediator and to permit policyholders who had used this avenue to refer the matter to the Personal Investment Authority Ombudsman, should they remain dissatisfied.

Further to 18/06/2001 [18:08], Chief Counsel B queries with Line Manager E how the Rectification Scheme fitted with the compromise scheme.

[17:45] Line Manager E explains that the compromise scheme would buy out GAR rights that had not yet been exercised, rather than the Rectification Scheme which was relevant to GAR policyholders who had not taken an annuity at their guaranteed rate before the House of Lords’ decision.

Equitable send FSA copies of correspondence that they had had with the Guernsey Financial Services Commission about the differential treatment of international policyholders. Equitable’s reply to the Commission states:

I’m not sure that I agree that a new angle has been reopened up by the [Society’s Counsel’s] Opinion. The issue of ring fencing was clearly before the House of Lords and, while it is undoubtedly extremely difficult to discern their intentions, there is no doubt whatever that they were aware of the existence of non UK business, and that they appeared content to allow a measure of ring fencing in that case. Whether or not this is consistent with the remainder of their judgement is virtually impossible to say …

We are in regular dialogue with the FSA as you may imagine, and we will raise this issue specifically at our next visit … We have asked [Counsel] to undertake further work to see if clarification of some of the more obscure implications of the judgement is achievable.

FSA’s Line Supervisor C notes: ‘I don’t remember this point, do Guernsey want their policies ring fenced and excluded from GAR exposure? Or are they concerned about being ring fenced in some other way?’.

Equitable send FSA written answers to the questions raised in their letter of 14/06/2001. In relation to question 10, Equitable say that:

This is a difficult issue. Our current thinking subsequent to the 7 June Actuarial Report is that the calculation of enhancements should be in two stages.

In the first stage, the total costs of GARs would be calculated on a “best estimate” basis using assumptions based largely on previous experience (other than the interest rate assumption, of course). For Group Pensions business that would mean basing the costs of GARs based on a take-up rate which was closer to 40% rather than being 60% (as in the  7 June report). That would establish a value for the costs of GARs which would be met by non-GAR policyholders.

In the second stage, that calculated total cost of GARs would be allocated on the basis of the relative potential values of the GAR options (by assuming a 100% take-up rate by all policyholders). The enhancements for Group Pensions would be exactly the same as for Individual Pension Plans and would take no account of the fact that the take-up rates for the two groups of policy were significantly different.

This approach is illustrated by the following example calculation using the values tabulated in section 4.4 of the 7 June Actuarial Report. The first column shows the first stage calculation of the total amount to be distributed assuming a 40% take-up rate for Group Pensions and 60% for all other groups of GAR business, which is £1,363m. The second column shows the second stage calculation based on a 100% take-up rate (and the same GAR annuity format for both Group Pensions and Individual Pensions business) to determine the allocation percentages shown in brackets. Those percentages are applied to the £1,363m total value from the first column to calculate the value allocated to each of the three groups of GAR policy which is shown in the third column.

The fact that members of some group pension schemes can receive very generous annuity rates from their schemes is not the concern of the Society and is something that cannot be measured (i.e. because the Society has no details).

FSA hold an Equitable Life Lawyers Group meeting. Chief Counsel B notes that, in relation to the compromise scheme, Counsel had expressed the view that ‘FSA’s interest lay in the fairness of the scheme proposed by Equitable’ and that ‘it was probably inappropriate for the FSA to form a view as to the number and make up of the classes of policy holder as this was a matter to be determined at the final hearing and not at interlocutory stage’.

Chief Counsel B informs the group that a lawyer had been appointed on secondment to look at the complaints under the Unfair Terms in Consumer Contracts Regulations 1999 about Equitable’s application of the market value adjuster.

Under ‘Any Other Business’, Chief Counsel A notes that Equitable’s Board was due to consider the compromise scheme proposals on 25 July 2001 and that this date: ‘was now quite close and as yet the FSA had not received fundamental GAR and non-GAR material and some that had been received was not in the correct form … [Chief Counsel A] stated that no draft scheme had yet been seen only internal uncompleted actuarial reports plus various pieces of oral information provided at weekly meetings’.

Chief Counsel B informs the group that: ‘it had still not been resolved as to whether the Equitable’s legal advice and board minutes could be shown to the FSA. Whilst the company had not yet refused access they probably would do so on the basis of legal advice. It was generally felt that we could not demand the advice as there was no relevant power in [ICA 1982]’. Legal Adviser A undertakes to confirm the position.

FSA’s Line Manager E prepares ‘some fairly general propositions’ on the tests that FSA might apply for evaluating the compromise scheme, which are set out under the following headings:

Is it better than any alternatives?

Line Manager E notes that the compromise scheme, by its very nature, involved some kind of loss of rights, and that: ‘It would … seem likely that were the offer a more attractive proposition for policyholders than the rights they currently enjoy, that the Society would not need to go through this process to achieve its objectives’. He says that, therefore, FSA:

… need to consider whether the alternatives are any better. The alternatives appear to be a sale of the business to achieve new capital support (ruled out), a winding up (or similar) process under the Insolvency Act 1986 (undesirable consequences) or continuing without the benefit of the compromise.

Is it fair?

Line Manager E notes that it would be difficult to achieve fairness to all policyholders where they did not all have the same kind of rights that were being given up, and that FSA:

… need also to recognise that may be difficult where there are a range of uncertainties that make it … impossible to establish the future worth of the rights in any particular case. By implication this means that an averaging process must be used. Our analysis must therefore consider whether the basis for the averaging is fair, so that it does not aim or have the effect of treating one group materially, and deliberately, worse than another.

Is it reasonable?

Line Manager E notes that the answers to the first two questions were important elements in deciding whether the scheme was reasonable.

What are the justifications?

Line Manager E explains: ‘In order to reach a view on these things, we will require some explanation of why a particular methodology was used to decide between different potential choices. This includes having an understanding of the underlying assumptions made to decide on the variables to be used for the calculations, and having evidence to justify those choices’.

Burden of proof

Line Manager E says: ‘Notwithstanding the above, there are difficult choices about the severity of the test. For example, do we have to be satisfied that the scheme is “fair” or “not unfair”. To the extent that there is likely to be a material difference between the two, it seems to me that “not unfair” is the more appropriate test on the basis that if there is a grey area, the voting and court process provide adequate additional safeguards to ensure that an unfair (etc) is not adopted, without the FSA needing to be interventionist to the point of preventing individuals exercising their own reasoned choices’.

FSA’s Head of Life Insurance sends Line Manager E a note on the ‘Development of FSA’s Position’ with regard to the compromise scheme, further to a brief discussion about the issue that morning between the Head of Life Insurance, the Director of Insurance and the Director of GCD. The Head of Life Insurance explains that it had been agreed that it would help to ‘concentrate our minds’ to focus on two practical aspects, with the first being:

Our response to Equitable’s request for an indication of the criteria against which we would judge their compromise. You have already set some work in hand on this. I set out below my attempt at some criteria, taking account of the discussion with [the Director of Insurance] and [the Director of GCD]:

1. The compromise should be as fair as possible to all policyholders, bearing in mind the practical constraints (including the timing constraint imposed by Halifax’s deadline for further financial support);
2. The proposal should leave no policyholder worse off than he or she would be in the absence of a compromise, bearing in mind the likely alternative scenarios;
3. The compromise should be fair enough to enable the Court to enforce it on all policyholders.

The Head of Life Insurance asks Line Manager E for comments on this ‘first shot’. Secondly:

We agreed that it was not too soon to begin to consider what we would wish to put in an FSA information sheet to policyholders, assuming that we decide in due course to issue one. It is likely that there would need to be at least two elements to this:

1. Our comments on the compromise scheme (which we cannot draft yet, as we do not have enough information from Equitable);
2. A description of the alternatives if the scheme is rejected. These would include: 
   1. Winding up
   2. The company staggering on. This scenario should be broken down into at least two alternatives, representing “best” and “worst” scenarios. The “best” scenario would be a fund which was still exposed to GAO liabilities, including the risk of further top ups; the “worst” scenario would envisage in-fighting between different groups of policyholders, costly litigation draining the fund, and the departure of the current chairman and chief executive, and possibly other members of the board and management.

The Head of Life Insurance asks Line Manager E to prepare a draft, with contributions from others, including their Insolvency Practitioner, on the winding up alternative, and from their actuaries, on the financial implications of the various scenarios, ‘which … should be quantified as far as possible’.

[14:15] FSA’s Managing Director A says that this was going to be ‘a hugely important piece of work … [and] it is vital that we get the whole of the FSA’s relevant resources in on this’. On the substance of what FSA needed to do, he writes that he was not clear whether Equitable’s proposals involved non-GAR policyholders giving up any rights (‘misselling or whatever’), and:

… This seems to me to matter enormously, because it will affect what we are able to say. Personally, I hope the compromise covers everything, as I see no other way to clear the ground and let the Society make a fresh start; but if it is to do that, there are more issues for us to cover. What are we to say about the worth of the possible claims for mis-selling especially given the potential conflict seeing that we are one of the parties who would almost certainly be involved in a dispute over whether or not mis-selling had occurred.

FSA’s Managing Director raises a second point, that he believed:

… [the Head of Life Insurance’s] criterion “no-one should be worse off than they would be under no compromise” is a highly debateable one. First, is it tenable? It would seem to mean current GAR holders probably being offered more than a compromise in aggregate can “afford” (the capital uplift in return for loss of the income guarantee is obviously pretty unattractive for some sub-sets of the GARs). The only way it might be tenable would be if the compromise were all-inclusive and if the non-GAR holders’ chances of undermining the [House of Lords’] judgement seemed pretty high (that might be enough to frighten the GAR holders into accepting less) and/?or if the compromise were much more complex than hitherto anticipated. [This would allow a closer correlation between current value of individuals’ guarantees and what was offered in the compromise; its great drawback is the likelihood that it would proliferate the number of classes and render acceptance very unlikely].

Second, there must be other versions of the criterion that might attract more support [in economic jargon this is a welfare maximisation problem and there are numerous different optima that can be postulated. If so we need to have fleshed out how the compromise would look on these different criteria].

Managing Director A raises a final point which is his ‘biggest worry (on which we have touched on several times in recent weeks)’, that is:

… what information can reasonably be provided to policyholders. [The Head of Life Insurance] has clearly picked up the need to address the counterfactuals – they will be difficult. Where I have [no] real feel is over information on the compromise itself. [Briefly], most policyholders … probably feel they are owed nothing less than a “market valuation” – of undoubted veracity (and thus preferably not provided by Equitable) for their own personal situation (in some cases with bells and whistles e.g. “what would my market valuation be if there is no compromise and I put in £x a year for the next 5 years?”) Can such things be provided? I rather doubt it. Can people be given a “do-it-yourself” pack? If yes then why can’t the Society do it for them? And so on.

What I fear we are going to get is some kind of generic representation of the “typical policies for a man aged 40 who has been contributing for 10 years” variety. Surely we are going to have to satisfy ourselves that what is proposed is the best that can reasonably be done in the circumstances.

FSA’s Managing Director A concludes by saying: ‘I also fear (I hope someone can prove me wrong) that a terrible [public relations]/real quagmire exists for us over the whole issue of the subtle tradeoffs there will be between overall cost, fairness to the individual, simplicity of the scheme, and information that is needed for a proper assessment by the individual’.

[16:34] The Head of Life Insurance says that FSA would involve their Consumer Relations Directorate and others. He says that FSA were pressing ahead with the aspects of the scheme that were not dependent on issues that Equitable were yet to make decisions on.

[16:58] Line Manager E provides some further information in response to the Managing Director’s comments. On Equitable’s timetable, he says that Equitable were expecting FSA to give a ‘no fundamental objection clearance’ before their Board meeting on 25 July 2001. On his first point, Line Manager E explains that Equitable’s current proposals were for a compromise of GAR rights only but: ‘[Counsel] has been commissioned [by Equitable] to report back in time to inform the final design, and decisions on what should be done about possible miss-selling claims will be taken once they have received his report. At the moment they are working on the basis that there is no grounds for action, or that if there were the cost would be minimal’.

On his second point, Line Manager E writes:

That “No-one” should be “worse off” is clearly a very high hurdle to clear, and in its strictest terms would make any scheme unattractive because of its cost. I suspect we need to think of people not being worse off in aggregate (against some benchmark yet to be determined – but presumably centred around current experience about the variables on interest rates, annuity rates, mortality, retirement patterns and so on), and that within that generality, no one is being treated in an especially discriminatory and disadvantageous way.

Line Manager E says that he shared the Managing Director’s initial thoughts on the information to be provided to policyholders and that:

… I think to the extent our powers (including those of persuasion) allow, we will need to ensure that the Society takes this very seriously … Presumably the court will not accept the scheme unless it clearly specifies what people will get (and people can be demonstrated to have known this at the time they voted). Given the discretionary nature of the benefits under a with-profits contract, there must be a process that will lead to GAR policyholders being given some kind of statement. What is possible or desirable needs thinking through very carefully since, among other things, there will be a trade off between the amount of information and consumer friendly presentation. I had proposed to bring [FSA’s Consumer Relations Directorate] more directly into the loop once the package had been settled sufficiently for us to work up some ideas. That detailed information probably needs to [be] ready for the end of the summer when the offer is formally made, but there is clearly a communications job to be done before then.

FSA’s Head of Actuarial Support tells Chief Counsel A that he was uncomfortable with Equitable’s response to question 10 raised on 14/06/2001 [15:14] and he suggests that FSA should seek the advice of Counsel on it. The Head of Actuarial Support also says that FSA did not yet have enough information ‘to feel comfortable with the level of uplift to be offered to each possible sub-group of policyholders, and in particular the extent to which this might vary by age’.

FSA hold a conference with Counsel with the purpose ‘to discuss/decide whether the FSA could approve in principle Equitable’s proposal to base s.425 Compromise on a value of GARs discounted by 60%’. FSA record that:

[Counsel] pointed out that if the Equitable was insolvent then there would be a calculation of the just estimate of the full GAR rights.

It was agreed that unless the threat of insolvency was more real than presently indicated in Equitable’s documents to-date, a s.425 Compromise could not be justified … the Actuarial Report dated 7 June 2001 did not indicate that the With-profits fund was under any threat of potential insolvency.

[Chief Counsel A and Scrutinising Actuary F] explained that Equitable’s statutory returns as of 31.12.2000 showed assets of approximately £400m only ie the Equitable was holding £1.6bn to cover £1.2bn for a total fund of approximately £34bn. [Chief Counsel A] said that the FSA was satisfied that the Equitable’s financial situation was sufficiently uncertain to justify a s.425 Compromise.

… [Counsel] warned that a court would be unlikely to sanction a s.425 Compromise which required policyholders to give up valuable legal rights if it was solvent. [Counsel] queried whether a regulator should permit such a use of the s.425 procedure. Further there was some doubt in legal circles as to whether it should be used by solvent insurance companies. [Chief Counsel A] said in [the case of another company] that s.425 Compromise policyholders were giving-up only the potential right to a future distribution of assets.

Counsel states that ‘FSA could only provide the indicative approval the Equitable sought by its 25th July Board Meeting if it was satisfied that the s.425 Compromise was better than any other alternatives’.

Counsel agrees that Equitable’s answer, in response to question 10 in FSA’s letter of 14/06/2001, that ‘Equitable would calculate the cost of the GAR at 40% and then distribute on the basis of 60% take-up was highly questionable’.

Chief Counsel A says that an option that had not yet been explored by Equitable was to buy out GAR top up rights only. It is noted that this would ‘deal with the supposed instability of the With-profits fund but would leave the Equitable with the problem of reserving on a prudent basis of full take-up of GAR rights’. Counsel suggests that FSA might need to require an explanation for why Equitable had based the compromise scheme on a 60% take-up rate of GARs when they had been required to set their reserves on a 90% take-up rate.

Chief Counsel A also reports that Equitable’s Board were that day considering whether to ‘exercise its contractual right not to allow policyholders to top-up where no premium had been paid in the previous year’. FSA note that it had been agreed that ‘notice to policyholders was an essential requirement’ and that ‘Counsel queried whether the Equitable could now enforce this right having not done so for 20 years’.

Under ‘Conclusion’, it is recorded that ‘Counsel advised that if s.425 was properly reasoned then there was no legal reason why the Equitable should not put forward a compromise based on the cost of the GARs rather than value and that FSA could properly indicate its approval to such an approach’.

Under ‘Action Points’ it is agreed:

• GAD to do further work on the value of GAR rights as opposed to the cost.
• Equitable to be asked to consider valuing GAR rights by the Financial Option Theory method.
• Equitable to be asked to do further work and provide an explanation for the lower take-up rates of GAR rights by group schemes.
• [Chief Counsel A] to raise with Equitable/[their solicitors] the need for proposed Pre-Directions Hearing on voting classes.
• FSA to send a letter to Equitable supporting in principle the cost as opposed to value approach in calculating GAR rights.